The following item is a Letter of Intent of the government of Estonia, which describes the policies that Estonia intends to implement in the
context of its request for financial support from the IMF. The document,
which is the property of Estonia, is being made available on the IMF website
by agreement with the member as a service to users of the
IMF website.

The attached Memorandum of Economic Policies describes the
policies the Government and the Bank of Estonia intend to follow in 2000 and in the first half of
2001. The currency board arrangement is a corner stone to our policies and fully consistent with
providing a strong foundation for rapid and sustained economic growth through maintaining
macroeconomic stability and increasing the efficiency and competitiveness of the Estonian
economy. We will reduce the budget deficit, and initiate a number of key long-term reforms,
including in public finances and administration, the pension system, and the financial sector as
well as further restructuring and privatization of the few large infrastructure companies still in
state hands. This economic reform program will also be an integral part of our EU accession
strategy. In support of these policies, we are requesting a stand-by arrangement in the amount of
SDR 29.34 million for the period until September 2001. Our balance of payments has
strengthened substantially in 1999 despite an adverse external environment, and we do not
anticipate that a need for any purchases under the arrangement will arise.

We believe that the policies described in the attached memorandum are adequate to achieve
the objectives of our economic program, but we will take additional measures to meet these goals
should the need arise. During the period of the arrangement, we will consult with the Fund on the
adoption of any such measures that may be appropriate in accordance with the Fund's policies on
such consultations. Further, we will conduct with the Fund two reviews of economic
developments and policies under the program, the first by end-June 2000, and the second by
mid-December 2000. In addition to a comprehensive evaluation of economic performance under
the program, the first review will focus particularly on the evolution of Estonia's fiscal position,
and the pace of economic recovery and its impact on the balance of payments. The second review
will focus on the budget for 2001. The program will also be evaluated on the basis of a number
of quarterly quantitative as well as one structural performance criteria, and structural benchmarks
(enumerated in the attached annexes to the Memorandum of Economic Policies). Performance
criteria for end-March 2001 and end-June 2001 will be specified at the time of the second
review.

I. Recent Economic Developments

1. Economic developments in the second half of 1998 and for much of 1999 were
dominated by fallout from the Russia crisis that broke in August 1998. The overheating of the
economy in 1997, banks' exposure to the stock market and an asset price bubble, and excessive
credit growth fueled by easy access to foreign financing, had left the Estonian economy, and
particularly the banking system, vulnerable to shocks. Contagion from Asia and the stock market
reversal in late 1997, the unexpected and sharp contraction of eastern export markets, and further
disturbances in international capital markets triggered by events in the CIS imposed a heavy
burden of adjustment on most sectors and regions, especially those that relied heavily on the
Russian market (notably the agricultural sector). While the impact of events in late-1997 on the
Estonian banking system and internal capital markets was short lived, it contributed to an
acceleration of the restructuring of the banking system and a pronounced slowdown in bank
lending. The latter reflected also a more cautious assessment by banks of the risk of lending to
firms with exposure to CIS markets. In combination, these elements reinforced the slowdown in
economic activity. After peaking at nearly 11 percent in 1997, real GDP growth declined to 4
percent in 1998, and real GDP is estimated to have fallen in 1999 by about 1 percent.

2. The pronounced weakening of economic activity in 1998, which was accompanied
by an unexpectedly rapid decline in the rate of inflation, also served to invalidate the fiscal and
financial program targets under the economic program of the government and the Bank of
Estonia for 1997-1998 as outlined in the Memorandum of Economic Policies (MEP) of
November 7, 1997. 1

3. The early reorientation of exports from Russia and other CIS countries toward
Western and Central European markets has helped to limit the impact of the Russia crisis. While
the agricultural sector has been severely affected by the downturn in Russia, export-oriented
manufacturing has continued to do well, taking advantage of Estonia's low-cost business
environment and its skilled labor force. In combination with a weakening of import demand on
account of the economic downturn, this resulted in the current account deficit declining from a
peak of 12 percent of GDP in 1997, to 9 percent of GDP in 1998, and an estimated 4 percent of
GDP in 1999.

4. After a budget surplus equivalent to 2 percent of GDP in 1997, the general
government registered a deficit of 0.3 percent of GDP in 1998 (EEK 0.2 billion) as a
result of the impact of the economic slowdown on revenue collection and slippages on the
expenditure side toward the end of the year. The general government fiscal position deteriorated
further in early 1999 as continued weak revenue growth coincided with substantial increases in
public sector wages and pensions. In addition to the weaker economy, a number of one time
factors also contributed to a pronounced contraction of revenues in the first quarter of 1999
(faster VAT rebates, changes in the due dates for the payment of social insurance taxes, and the
reorganization of the social tax collection system). However, the influence of these factors had
faded by mid-year. To reverse the widening of the budget deficit, the government introduced a
supplementary budget in June 1999 that reduced authorized spending in the second half of 1999
by about 1.3 percent of annual GDP (or EEK 1 billion). Together with additional expenditure
restraint, the budget deficit in the second half of 1999 was kept to 3.0 percent of GDP and
the deficit for the year to 4.8 percent of GDP. The deficit was largely financed through the
use of the proceeds from the partial further privatization of Eesti Telekom in early 1999.

5. The practice of holding part of the government's cash balances abroad began in late
1997. The original objective was to sterilize the impact of the fiscal surpluses and privatization
proceeds. Initially these balances represented the counterpart of fiscal surpluses accumulated in
1997 and early 1998, but these were later augmented by the transfer of about half of the
privatization proceeds from the Eesti Telekom sale in early 1999. These resources are managed
by the Ministry of Finance consistent with guidelines agreed with the Bank of Estonia that limit
investments to assets of the highest quality. After the inflows associated with the Eesti Telekom
receipts, the balances in the government accounts held abroad rose to EEK 2.8 billion in
mid-1999, but then fell to EEK 2 billion (or 2.7percent of GDP)
at year-end, reflecting the use of these resources to finance the fiscal deficit in the second half of
1999.

6. Included in government deposits held abroad are the assets of the Stabilization
Reserve Fund (SRF). The SRF was established mainly as a contingency reserve in case of
macroeconomic emergencies. Legislation that became effective on January 1, 2000 further
articulated the sources and uses of funds held in the SRF. It provided for the transfer into the SRF
of, inter alia,all surpluses of the state budget, selected privatization receipts, and other
one-off revenues (including dedicated transfers from the state budget). In addition, profit
transfers from the Bank of Estonia may also be added to the SRF. The operations of the SRF are
overseen by its Board which includes, inter alia, the Minister of Finance and the Governor of the
Bank of Estonia. In the absence of exceptional and unexpected financing needs, the government
foresees that the bulk of SRF resources would be used to finance the pension reform. The use of
SRF resources for any purpose will require approval by parliament. In the period ahead, we are
committed to add all further proceeds from the privatization of the remainder of Eesti Telekom to
the SRF and to keep all SRF resources in accounts abroad.

7. Monetary and credit developments during late 1998 and 1999 reflected primarily
the deterioration in the international financial environment following the Russia crisis, the
subsequent slowdown in economic activity in Estonia, and the restructuring of the banking
system. Weak demand for credit, combined with more cautious bank lending policies as a result
of increased risk perception because of the economic downturn, has kept total credit to the
private sector broadly unchanged in the year through mid-1999 after which some modest increase
in lending was experienced. There has been a rebound in broad money growth since mid-1999,
reflecting increased financial savings by households; part of this rebound served to offset the
monetary contraction experienced in the second half of 1998. While there had been a pronounced
increase in interest rates after the onset of the Russian crisis in August 1998, nominal interest
rates began a steady decline late in 1998 and are now at historic lows.

8. During 1998, the banking system suffered the delayed consequences of excessive
risk taking and weak management practices during the boom period of 1996-97. A number of
banks, especially the smaller ones, experienced difficulties in dealing with the unexpected
deterioration in the international financial environment and the weakening of their loan portfolio
as a result of the impact of the contraction of Eastern export markets and the economic slowdown
on their clients. As a result, in the period June-December 1998 a total of four banks failed
(representing 14 percent of total bank assets at end-March 1998). Maapank, EVEA, and ERA
Bank were declared bankrupt, while Forekspank was taken over by the Bank of Estonia and
merged with the Estonian Investment Bank to form Optivabank. These adverse developments,
however, were outweighed by two large mergers and the acquisition of strategic equity stakes by
foreign investors in the two largest Estonian banks (Hansapank and Uhispank--with a combined
share in total bank assets of 85 percent--that together materially strengthened the financial
system. By end-1999 only six banks (including one new bank that was granted a license in
September 1999)--plus one foreign branch--remained in operation in Estonia. We view this
process of bank consolidation as healthy and a normal consequence of an accelerated transition to
a market economy.

9. Since late 1997, the Bank of Estonia has been implementing a major long-term
program of strengthening prudential regulations and improving banking supervision with
technical assistance by the IMF. To address concerns regarding bank stability following a period
of rapid credit expansion in 1997, late that year the Bank raised the capital adequacy ratio to 10
percent and the reserve requirement to 13 percent. These ratios have been kept at these relatively
high levels despite the consolidation in the banking system mainly to ensure that confidence in
Estonian banks remains unshaken. Prudential oversight was also strengthened through, inter alia,
the inclusion of bank guarantees in the basis for the calculation of the capital adequacy ratio, the
introduction of new limits on net open foreign exchange positions, and the application of
prudential regulations on a consolidated basis for bank groups. As a result, Estonia's existing
legal and institutional framework is consistent with full compliance with the Basle Core
Principles on Bank Supervision. In addition, the Deposit Insurance Fund became effective in
October 1998, the new Credit Institutions Law became effective in July 1999, and as of July 1,
1999, the Bank of Estonia has started to remunerate all commercial bank reserves at the
European Central Bank deposit rate. Together these measures can be expected to contribute to
creating a stronger and healthier regulatory environment.

10. With basic structural reforms completed for some time, the government's
attention is now focused on the more complex and difficult second generation reforms. The
process of restructuring and privatization of Eesti Energia (the electricity generation complex)
continued with (i) the conversion of Eesti Polevkivi (oil shale mining) in April 1996 into a joint
stock company and (ii) the establishment of a joint stock company (Narva Power Stations) in
November 1999 combining the two major power stations (with a majority interest in Eesti
Polevkivi to be added in the first half of 2000). The privatization of other state enterprises,
including Estonian Railways and the alcohol producers (Liviko and Moe), was either completed
or well advanced. A further 24 percent of Eesti Telekom was privatized in February 1999,
leaving only 27 percent of shares in the hands of the government. Land reform is
advancing with the restitution of land proceeding about as scheduled. In addition, amendments to
the Competition Law became effective in October 1998 improving compliance with EU
requirements, health reforms are well underway, and there has been substantial progress on
pension reforms. (Reforms in these areas are described in more detail below.) Moreover, Estonia
subscribed to the IMF's Special Data Dissemination Standard (SDDS) in September 1998.

II. Objectives and Strategy for 2000-2001

11. We have experienced the first significant cyclical slowdown since the beginning
of Estonia's transition to a market economy largely on account of the Russia crisis and related
events in CIS countries. However, CIS markets appear to be stabilizing and are even showing
signs of recovery, while Estonia's main export markets in the EU are expected to grow relatively
strongly in the period ahead. Moreover, disturbances in international capital markets have
subsided. Against this favorable background, the main challenge during the program period will
be to strengthen the fiscal position and to give new impetus to structural reforms. This will lay a
good basis for economic recovery and sustained economic growth.

12. In these circumstances, the joint objectives of the government and the Bank of
Estonia for 2000-2001 are to provide a strong foundation for rapid and sustained growth through:
(i) maintaining external and macroeconomic stability and (ii) increasing the efficiency and
competitiveness of the Estonian economy. To that end we will push ahead with a number of key
long-term reforms, notably in public finances and administration, the pension system, and the
financial sector as well as with further restructuring and privatization of the few remaining large
infrastructure companies where state participation is still dominant. Over the medium-term, these
measures should materially strengthen the working of market forces, improve resource
allocation, and provide an important boost to private sector confidence.

13. This economic and reform program will also be an integral part of our EU
accession strategy. The main goal of this strategy is to consolidate the substantial progress
already made toward meeting the "Copenhagen criteria" for EU membership,
particularly by maintaining a fully-functioning market economy and strengthening Estonia's
capacity to cope with competitive pressures and market forces within the EU.

14. Our economic objectives will be pursued in the context of our long-standing
currency board arrangement, which continues to provide a stable, transparent, and consistent
policy framework. As demonstrated by the sharp improvement in our current account position
and solid export growth to western markets, the current exchange rate peg remains appropriate.
We intend to maintain the current fixed relationship between the kroon and the DM and euro
until Estonia becomes a full participant in the EMU, at which point the euro will become
Estonia's currency.

15. The main macroeconomic parameters and targets underlying our program for
2000 are as follows:

Following the decline in output experienced in the first half of 1999 and the modest
recovery experienced in the second half, we anticipate that economic activity will further
strengthen in 2000. With CIS markets no longer in decline, we project the return to positive
economic growth to result primarily from the continued growth of exports to western markets,
supported by an initially moderate recovery in domestic investment and consumption demand.
With the banking difficulties now overcome, a flexible labor market, the exit of weaker
enterprises, price stability, growing integration with Scandinavian and other Western markets,
and the successful completion of first generation structural reforms, we believe that the Estonian
economy is well positioned for a renewed take-off of economic growth. Accordingly, we
estimate that growth will accelerate to about 4 percent in 2000. From 2001 onward,
we expect growth to reach 5-6 percent per annum, which we believe is a rate of growth
that can be readily sustained over the medium-term.

While in a small open economy with a fixed exchange rate, inflation cannot be
targeted, we project that CPI inflation will be about 4 percent in 2000 (on average).
Accordingly, we project an increase in nominal GDP in 2000 of about
8 percent.

Although competitiveness remains intact, and is expected to remain so over the
medium term, a moderate widening of the current account deficit to about
5½ percent of GDP is expected for 2000 due to the quickening pace of recovery in
domestic demand. However, we project that as a result of the prudent approach to fiscal policy
described below, robust private savings, and fast export growth, the current account deficit will
remain at sustainable levels over the medium term. We also expect that it will continue to be
financed primarily by non-debt creating flows.

As in 1998, FDI and portfolio investment inflows comfortably exceeded the current
account deficit in 1999--in large part due to the privatization of Eesti Telekom early in the year.
With substantial balances in government deposits held abroad and a strong improvement in the
net foreign asset position of the banking system, we estimate that Estonia's net indebtedness was
substantially reduced in 1999. We are confident that as the EU accession process advances,
Estonia will continue to attract considerable capital inflows, including foreign direct investment.
We note that Estonia has retained its investment grade credit ratings despite the turbulence in
international markets late in 1998.

16. The fixed exchange rate and currency board leave fiscal policy as the only direct
instrument for aggregate demand management. With signs of an onset of a moderate recovery
and the current account deficit at a level that can very likely be sustained over the medium-term
without significant increases in external debt, we believe that there is not a strong case for setting
budgetary policies from a short-term perspective either to stimulate the economy or to restrain
aggregate demand and the current account deficit. Instead, the primary objective of fiscal policy
in the present economic circumstances should be to promote the medium-term sustainability of
quality growth while safeguarding the progress already made in reducing the external current
account imbalance. In our view, this objective would be well served by aiming at a budget,
which, on average, is balanced over the medium term, while at the same time providing for a
gradual decline in the tax burden from 2001 onwards. This approach would also be consistent
with the harmonization of fiscal policy with EU requirements under the Growth and Stability
Pact.

17. Estonia has made rapid progress in the implementation of structural reforms.
Sustained structural reform effort will, however, be required to further improve productivity and
maintain export competitiveness, boost the supply response of the economy, encourage domestic
savings, and continue to attract foreign direct investment. Two key priorities in this regard are the
pension reform program and the privatization of the energy complex. In addition, we intend to (i)
make more transparent the structure of our public finances, inter alia, by consolidating into the
state budget the utilization of foreign loans and grants, (ii) start the reform of public
administration, including by increasing the transparency of public employment and remuneration,
(iii) strengthen financial sector regulation and move cautiously toward consolidating
financial sector supervision under one independent authority, and (iv) continue the reform
of the public health care system.

III. Policies

Policy design and coordination

18. In the context of its EU accession program, the government approved Estonia's
Medium-Term Economic Program (MTEP) for the period 1999-2003 in November 1999. The
MTEP establishes broad quantitative macroeconomic priorities over its program period and
outlines key structural reforms in the medium term. The policy framework set out in the MTEP is
fully consistent with the policies set out in this Memorandum. The government and the EU
Commission will conduct annual joint assessments of developments under the MTEP.

19. An essential element in the formulation of medium-term economic and reform
policy is the harmonization of the fiscal policy framework with EU requirements, which, inter
alia, call for Estonia's adherence to the Growth and Stability Pact, including taking effective
action on receiving information indicating the risk of an excessive deficit (greater than
3 percent of GDP). Certain provisions in the new Basic Budget Law (see
paragraph 28 below) willalready go a long way toward meeting this goal. Notably,
Estonia is already participating in a pilot project with the EU Commission and EUROSTAT,
aimed at training and familiarizing officials from accession countries with policy making and
control at the EU Commission level.

20. The government and the Bank of Estonia will by June 30, 2000 initiate an
assessment of the extent of Estonia's compliance with the Code of Good Practices in Fiscal
Policy and the Code of Good Practices on Transparency in Monetary and Financial Policies.
Based on the conclusion of these assessments, an action plan will be formulated to bring the
principles of policy making and reporting in full compliance with both codes. If necessary,
technical assistance from the IMF will be sought to that end. In addition, Estonia has agreed to
participate in the joint World Bank-IMF Financial Sector Assessment Program (FSAP) to help
identify strengths and weaknesses in its financial system; preliminary work in this area is
expected to get underway in February 2000.

Fiscal policy and public finance reform

21. The budget for 1999 had been formulated in mid-1998, during the run-up to the
national elections, on the expectation of continued fast real and nominal growth of the economy.
As noted earlier, however, the adverse external conditions facing the economy precipitated a
significant contraction in economic activity beginning in the second half of 1998 and continuing
through the first half of 1999. Together with the substantial increases in wages and pensions
awarded under the 1999 budget, and also the negative impact on revenues (estimated at
1 percent of GDP) of the one-time factors noted in paragraph 4 above, this contributed to
a marked widening of the public sector deficit to 8.6 percent of GDP in the first quarter of the
year.

22. The new government coalition that was formed after the March 1999 national
elections immediately took action to contain the fiscal deficit to 5 percent of GDP in the
second quarter. It also cut expenditures in the second half of 1999 through a supplementary
budget, and by deferring to 2000 about EEK 440 million of expenditures.

23. The budget for 2000, which was adopted by parliament on December 15, 1999,
originally had two main objectives (i) to achieve fiscal balance; and (ii) to reverse the trend of a
sharply increasing share of government in the economy. (Government expenditures reached
nearly 44 percent of GDP in 1999, up from about 38 percent of GDP in 1997.) To
that end, the 2000 budget provides for no general increase in nominal wages and pensions
(following a 20 percent increase in real terms in 1999). Including deferred expenditures,
spending on goods and services and transfers to households will show a moderate increase in real
terms, whereas investment spending will be reduced somewhat in real terms (as it will be kept
constant in nominal terms relative to the 1999 level). However, in accordance with our
preparation for joining NATO, we increased defense outlays from about 1.2 percent of
GDP in 1999 to about 1.6 percent of GDP in 2000. Taking into account the impact of
deferred expenditures, total expenditures in 2000 will be less than 4 percent higher in
nominal terms than the 1999 outcome, although expenditures in 2000 include self-financed
outlays of government agencies.

24. With regard to revenue, the budget for 2000 incorporates a number of important
tax policy measures. Effective January 1, 2000, we have taken the following measures:

the corporate income tax on retained profits was eliminated. This, we believe, will
remove the inefficiencies stemming from the double taxation of profits and will provide an
important boost to investments. At the same time, employee fringe benefits, including company
cars, became subject to income taxation;

the amount of personal income exempted from income tax was increased from
EEK 500 per month to EEK 800 per month;

agricultural import tariffs were introduced at, or below, WTO bindings (which are
below prevailing EU tariff levels). While the revenue impact of this measure will be small, this
step is intended mainly to ensure that a well functioning border control mechanism is established
and that Estonia will, in due course, be able to handle the administration of the complex EU trade
regime;

the excise rate for tobacco and tobacco products was raised by about
10 percent;

VAT rebates for exports can no longer be claimed for goods stored in customs
warehouses, but only for goods physically leaving Estonia.

In addition, excise rates for fuels were raised on average by about 25 percent effective
December 1, 1999. We will also take the following measures during 2000:

the approved budget is based on the nonrenewal of the zero VAT ratings (when they
expire in June 2000) for thermal energy, peat, briquettes, coal, and firewood sold to households.
These zero ratings, which are inconsistent with EU guidelines, had previously been extended
annually;

we will establish excise warehouses for alcohol, consistent with EU guidelines by
July 1, 2000. This measure is expected to improve the administration of excises on alcohol and
bring additional revenue to the budget;

we will introduce excise taxes on fuel components by July 1, 2000.

We project that the above tax policy and administration measures will generate additional
revenue in 2000 in the order of about EEK 1.9 billion (about 2.4 percent of
GDP). This additional revenue will broadly offset the revenue loss from the abolition of the
corporate profit tax and from the increase in the minimum personal income exempted from
income tax, which together is estimated to amount to about EEK 1.8 billion.

25. While parliament has passed a formally balanced budget for 2000, the deferral of
expenditure from 1999 to 2000 makes the goal of a balanced budget no longer attainable.
Moreover, the budget excludes foreign financed investments and net lending of about
EEK 310million. In addition, we recognize that there is a considerable
downside risk associated with our revenue projections for 2000. Specifically, it is difficult to
estimate precisely the additional revenue that will be generated from the tax policy and
administration measures outlined in the paragraph above. We are, however, firmly committed to
keeping the fiscal deficit of the general government in 2000 to no more than 1.25 percent
of GDP. To that end, we will monitor closely fiscal developments, in particular by establishing
monthly expenditure targets, to ensure that the fiscal deficit path during the course of the year
remains consistent with our target for the year as a whole. We also stand ready to take additional
measures, if necessary, to contain the fiscal deficit. These measures could include
(i) extending to the whole country the car tax that currently applies to Tallinn;
(ii) introducing an excise tax on heavy heating fuels; and (iii) cutting end-year bonuses for
public sector employees. Finally, in the event of unexpected developments leading to a
significant widening of the fiscal deficit, the government will be prepared to submit to parliament
a supplementary budget with corrective measures. In contrast, any excess in budget revenues
over projected amounts will be used to reduce the general government fiscal deficit further.

26. With regard to 2001, we are aiming at a balanced budget, excluding any impact of
further pension reforms. We intend to reduce general government expenditures (as a ratio to
GDP) further by keeping the general government outlays constant in real terms. Over the medium
term, we aim at broad budget balance, including the impact of the pension reform.

27. In the coming years, public expenditure priorities will be affected by a number of
factors. First, the need to maintain a sufficient social safety net for vulnerable groups, e.g.,
pensioners, large families, the unemployed, and population located in less developed regions,
will necessitate continued significant outlays. The pension increases given in 1999 have done
much to strengthen the income of the retirees. In the long run, pension reform (described below)
will contribute significantly to the welfare of the elderly. Second, preparation for EU accession
will place an increasing burden on certain areas of public spending in the next few years,
particularly transportation, energy, and the environment. The need for this spending is dictated by
our primary strategic goal of joining the EU as quickly as possible. While these outlays will tend
to widen the budget and current account deficits, we also expect to receive substantial financial
support, much of it in the form of grants, in preparation for EU membership. Our foreign policy
objective of integrating Estonia into NATO will also require some further increase in defense
spending over the medium term. Nevertheless, we are determined to limit and even reduce
further the share of government in GDP over time. We expect that this will become easier with a
return to brisk and sustained economic growth.

28. During 2000-2001, we intend to continue modernizing our public finances and to
address the existing structural weaknesses of the budgetary process. Some of these rigidities are
dictated by our constitution--notably the significant degree of fiscal autonomy of local
authorities--which restricts the ability of the central government to control general government
finances. Nonetheless, there is room for improvement in a number of other areas.
Specifically:

To assist in the management of fiscal policy and to ensure a comprehensive
overview of public sector operations the Ministry of Finance has started publishing monthly data
on the basis of the fully consolidated general government as of May 1998;

We will further improve cash and deposit management by the Treasury and by state
agencies outside the Treasury framework. The distribution of central government deposits among
domestic financial institutions will be governed by the principle of minimizing risk to taxpayer
money. As of March 1, 1999, the Treasury started reporting publicly at the end of each
month the amounts of central government deposits in each bank, as well as those held abroad.
Moreover, the government in September 1999 approved general investment guidelines for all
state assets. As an essential part of this new framework, the Ministry of Finance set up a Risk
Management Committee (RMC), that includes representatives from the Ministry of Finance and
the Bank of Estonia. The main task of the RMC is to oversee risk management practices relating
to the investment of state assets by both the Treasury and other government agencies. The
statutes of the RMC have been approved together with detailed risk management guidelines for
the Treasury;

In recognition of the importance for the execution of fiscal policy of fully integrating
local authority financial operations into the general government budgetary framework, the
government and the Bank of Estonia will continue to monitor local authority borrowing with a
view to preventing the incurrance of new debt that is regarded as excessive in relation to local
budgets or the overall stock of local and national debt;

We are drafting, with technical assistance from the IMF, a new Basic Budget Law,
that will, inter alia, provide for the inclusion in the central government budget of the utilization
of all foreign loans and grants and gaining greater control over local authority budgets, including
their borrowing programs. The new law will be submitted to parliament by June 30, 2000.
This measure is also a structural performance criterion.

Monetary and Financial Policies

29. The government and the Bank of Estonia remain fully committed to the
maintenance of the currency board and the current fixed relationship between the kroon and the
DM and euro. We believe that this provides an appropriate framework for the preparation for
accession to the EU and for full participation in ERM2.

30. The strategic aim of the Bank of Estonia over the medium term is to ensure the
readiness of Estonia's monetary policy framework to join the European Union by January 1,
2003. To that end, the Bank of Estonia, will, in cooperation with relevant EU institutions,
prepare during the course of 2000 a detailed analysis of Estonia's monetary legislation to
guarantee full conformity with EU legislative requirements. Any necessary legislative changes
will be submitted to parliament by December 31, 2000.

31. The Bank of Estonia's overall objective in managing the financial system is to
guarantee that the banking system is well-managed, maintains sufficient capital and liquidity to
withstand internal or external shocks, and that the Bank of Estonia is able to monitor
developments in a timely and effective fashion so that it can take early remedial action should the
need arise. To that end, the Bank of Estonia will, during the program period, strengthen the
operation of the currency board and the financial system by reviewing the operation of the
prudential framework, upgrading its monitoring and analytical capacities, and ensuring
appropriate levels of central bank reserves in excess of currency board cover to help deal with
any unforeseen shocks. Specifically, the Bank of Estonia will:

finalize by March 31, 2000 the review of the current structure of reserve
requirements and additional liquidity requirements and introduce the relevant changes by June
2000 with the aim of reducing market distortions inherent in the current monetary framework. In
particular, we will review the adequacy of the current rate at which commercial bank deposits at
the Bank of Estonia are remunerated, the categories of assets eligible for meeting the reserve
requirement, and the method of calculating liabilities subject to the reserve requirement. These
changes will not compromise the level of liquidity buffers of the currency board system. No
changes are foreseen in the capital adequacy ratio, which will remain at 10 percent of
risk-weighted assets;

introduce by March 31, 2000 an enhanced internal Early Warning System to detect
in good time difficulties faced by the financial system;

develop by December 31, 2000, together with the government, a common
framework for addressing solvency and liquidity crises in the banking system with the aim of
creating a transparent environment for ensuring the stability of and confidence in the banking
system. In developing such a framework, due account will be taken of the basic principle that
addressing strictly short-term liquidity difficulties would normally be the responsibility of the
Bank of Estonia and that all other demands would fall on the budget. Moreover, the currency
board arrangement strictly limits the financial scope for intervention by the Bank of Estonia.
Intervention should thus be entertained only when crises take on a clearly systemic
character;

complete by December 31, 2000 a study of the terms and the structure of private
sector credit lines and other market-based instruments presently used by the public sector and the
private sector (especially commercial banks). This study will evaluate the resilience of the
Estonian financial system to internal and external shocks and its ability to ensure access to
adequate financing in times of market disruption. The material strengthening of the banking
system through the process of consolidation in the period through 1998 and the entry of foreign
strategic investors provides an important opportunity to work, together with commercial banks,
toward a more robust financing environment. In addition, the Bank of Estonia will intensify
contacts with key private creditors to the banking system to guarantee an appropriate and timely
exchange of information.

32. The Bank of Estonia established in October 1999 a framework for profit
transfers
to the state budget that takes account of the need to maintain sufficient medium-term central
bank capitalization and provides for an adequate level of net international reserves over the
minimum currency board coverage consistent with the Law of the Bank of Estonia. Within this
framework, the profit transfer to the state budget will be limited to up to 25 percent of the Bank
of Estonia's annual profits in the years ahead.

33. The difficulties faced by the banking system in 1997 and 1998 have strengthened
our determination to improve further the regulatory and supervisory environment of our banking
system and to make the financial system more transparent. To that end, we have taken the
following measures to strengthen supervision:

The Bank of Estonia introduced bank supervision on a consolidated basis in early
1998 and has been refining associated procedures on an ongoing basis. Further improvements are
planned in this field, e.g., in on-site supervision of consolidated institutions as well as in the
improvement of the analytical basis for the off-site supervision of consolidated groups;

A revised Credit Institutions Law was made effective on July 1, 1999. This law
materially strengthens the ability of the Bank of Estonia to enforce prudential standards and helps
bring the supervisory standards into compliance with the Basle Core Principles, and
internationally accepted practices;

We implemented inOctober 1999 revised disclosure requirements for
commercial banks reporting on a comprehensive and uniform basis, including bank's off-balance
sheet exposure in annual reports. The first reports based on the new disclosure requirements will
be published by end-February 2000;

We revised in October 1999 the regulatory framework to make full use of the
possibilities afforded by the new Credit Institutions Law. Specifically, we introduced new or
revised regulations relating to the licensing of new banks, "fit and proper" criteria for
bank owners and managers, and the circumstances under which holdings in banks in excess of 10
percent of total capital can be acquired or increased;

To facilitate supervision on a consolidated basis, the Bank of Estonia has prepared a
manual with the complete set of internal regulations and will update and make any other
necessary changes to this manual as and when required.

To further raise standards of bank supervision, the Bank of Estonia will also take the
following measures:

Implement by March 31, 2000 an improved loan assessment framework, including a
uniform minimum loan-loss provisioning system that provides scope for partial provisioning;

We currently have a two-tier system in place for the evaluation of country risk and
transfer risk components in the capital adequacy calculation. We intend to review the need to
introduce a more articulated framework for this calculation. If necessary, we will introduce the
new framework by September 30, 2000;

To maintain a high standard of supervision, the Bank of Estonia also remains
committed to keeping the supervisory department appropriately staffed.

34. Although considerable strides have been made in bringing the supervision of the
banking system up to international standards, the supervision of nonbank financial
institutions--especially the securities industry--remains weak. The government and the Bank of
Estonia have decided on a comprehensive strategy for the consolidation of financial sector
supervision under one independent agency (the "agency") under the public law to
ensure that supervision over all financial operations in Estonia is conducted at a high and
uniform standard. With this objective in mind, and cognizant of the importance to the economy
and the financial sector of ensuring that the legislative, institutional, and organizational
foundations of the agency are well founded, the government and Bank of Estonia intend to take
the following measures in preparation for establishing the agency:

The government has already submitted to parliament the new Insurance Business
Law in September 1999 and will submit to parliament the new Securities Market Law by June
30, 2000. These laws will establish minimum standards, especially as regards regulation of
primary and secondary markets, avoidance of insider trading, and ensuring that minimum capital
and capital adequacy requirements are met. They will also provide supervisors with sufficient
authority and autonomy to effectively enforce these standards. These laws have been drafted
consistent with EU guidelines;

The government and the Bank of Estonia is establishing a joint working party to
prepare by June 30, 2000 the organizational and legal principles under which the agency would
be established and draw up a detailed action plan for setting up the new agency. In recognition of
the key role played by the banking sector in ensuring macroeconomic stability and the viability of
the currency board, we will ensure that there will be no compromise in the standard of
commercial bank supervision during the transition to a unified supervisory environment;

In addition, we will by June 30, 2001 submit to parliament all the necessary
legislative measures associated with the establishment of the agency.

35. The Compensation Fund was established in 1993 to serve as a mechanism for the
redemption of restitution and national capital vouchers that were not used to acquire privatized
housing, land, or equity in public share offerings. Under current legislation, these vouchers are
due to expire on December 1, 2000. We expect that further Compensation Fund bond issues in
the amount of about EEK 150 million will be made in the period through September 2000 after
which no further issues will be made. The government thus deems that the work of the
Compensation Fund will have been essentially completed and intends to terminate its operations.
To that end, further transfers of privatization proceeds to the Compensation Fund have been
halted effective January 1, 2000. The government will by June 30, 2000 complete a review of the
financial and legislative consequences of winding up the Compensation Fund and will in due
course propose legislation to parliament that would authorize the restructuring of the
Compensation Fund. We intend to make adequate financial provision for the servicing of all
Compensation Fund Bond issues through their final maturity. Allowing for the maintenance of a
reserve to redeem at market value any outstanding vouchers at the end of the voucher program, it
is estimated that the Compensation Fund will have assets in excess of its liabilities amounting to
approximately EEK500 million. The government's intention is that the
bulk of these surplus resources will eventually be transferred to the Stabilization Reserve
Fund.

36. In November 1998, the Bank of Estonia acquired at a cost of EEK 255 million a
controlling interest in the Optivabank as part of a bank rescue and restructuring exercise. The
Bank of Estonia believes that the interests of the Estonian banking system would be best served
if its equity share in this bank were to be purchased by an appropriate strategic investor. The
Bank of Estonia is firmly committed to the privatization of its equity stake and will continue its
effort to seek a fitting buyer for Optivabank. Market conditions permitting, we expect that the
sale will be concluded by June 30, 2000. In addition, the Bank of Estonia completed the disposal
of its modest stake in Hansapank in December 1999.

Other structural policies

37. Estonia has benefited from its liberal trade policies since the beginning of
transition. In particular, the absence of any import tariffs has minimized distortions in the
domestic economy and has helped establish Estonia's reputation as a bold reformer. This policy
was of considerable help in our accession to the WTO. Estonia was formally accepted into the
WTO on November 13, 1999. However, as EU membership is drawing near, we need to prepare
for harmonizing our trade policies with those in the EU. In part to demonstrate Estonia's ability to
administer a comprehensive trade and tariff regime, the government has effective
January 1, 2000 introduced tariffs that apply mainly to agricultural products. These tariffs
do not apply to imports from EU countries or from those countries with which Estonia has
concluded free trade agreements. Tariffs are at or below the binding limits agreed with the WTO
(which are below EU tariff rates). Our next priority will be to prepare and announce our
medium-term strategy of trade policy harmonization, so as to clarify our intentions
vis-à-vis our trading partners, as well as to create a transparent, stable, and predictable
policy environment for domestic producers and consumers.

38. Following a World Bank public expenditure review in 1997, we identified priority
measures for rationalizing the public administration and increasing transparency in public
employment and remuneration. We already established in December 1999two
departments within the Ministry of Finance that are charged with ensuring that spending by
government units (including ministries) is consistent with budgetary objectives, making certain
that these units are being managed in an appropriate fashion, and monitoring the use of EU
resources. We also established in late 1999 an Administration Reform Bureau within the
government responsible for developing and implementing its public sector reform strategy. The
main goals of the Bureau are to streamline and rationalize the central government and to realize
efficiencies in the structure of local authorities and other agencies of the government, including
through mergers. Financial incentives will be employed where deemed appropriate to expedite
this process. In addition we will also complete by September 30, 2000a review of
employment in the large education sector.

39. In 1997, we started the reform of our pension system with a view to creating a
three pillar system: (i) the first pillar would be a modified version of the existing defined benefit
program financed on a Pay-As-You-Go basis, (ii) the second pillar would be a compulsory and
fully-funded defined contribution program, and (iii) the third pillar would be a voluntary private
pension system, with contributions enjoying a tax advantaged status. The government is
receiving technical assistance from the World Bank to help frame these reforms and has also
sought assistance from the IMF.

We are proceeding with the reform of thefirst pillar. Effective with
the budget for 2000, pension contributions on behalf of selected disadvantaged groups (including
the unemployed) will be financed from general tax revenues. On April 1, 2000, we will
also provide, inter alia, for (i) the introduction of an earnings based component for new
pensioners based on the individual registration of pensions that started in 1999 (this adjustment
will be implemented in a cost-neutral fashion) and (ii) the indexation of pensions starting in
2001. Moreover, no general increase in pensions is foreseen for 2000. The retirement age has
been progressively increased starting in 1994; in December 1999 the retirement age was 62
½ years for men and 57 ½ years for women. The retirement ages for men and women
will be equalized at 63 years in 2016;

We intend to introduce the second pillar late in 2001 or early in
2002. To that end, by early 2000 and in cooperation with the IMF and World Bank, we will
complete detailed long-term projections of the finances of the first and second tier under
alternative assumptions. Not later than December 1, 2000 we intend to submit to parliament
legislation that determines the eligibility rules and formula for the calculation of second pillar
benefits, as well as the guidelines for management of second pillar funds;

The third pillar has already been put in place with the promulgation
by parliament of the Pension Fund Law in June 1998.As at November 30, 1999, one
pension fund and several life insurance companies (licensed to provide annuity products) have
started operations.

40. In 1997, we launched a major reform of Estonia's health system with the
assistance of the World Bank. In several areas, notably primary health care, significant progress
has already been made: a family physician system has been introduced, and family physicians
now provide about one-third of primary health care in Estonia and act as gatekeepers for
specialized medical care. The next major step is the reform of the financial aspects of the health
system, including the operation of the Medical Insurance Fund. The financial management of
hospitals has started to improve already as subsidization of their utility bills has stopped. In
addition, by June 30, 2000 we will formulate a restructuring and investment program for
Estonia's hospital network with the aim of improving efficiency and reducing costs. This
program would be subject to a phased implementation over the period 2001-2015.

41. Estonia is now at the final stage of its privatization program, with only a few large
enterprises and public utilities remaining in state hands. The work of the Estonian Privatization
Agency has therefore been deemed to have been completed and the government will wind up its
operations by December 31, 2000. As regards the remaining equity the state holds in the
enterprise sector, we intend to make further progress in the sale of these interests, while
according the highest priority to the quality of privatization and the proper safeguarding of
privatization receipts. In the nonenergy sector we intend to take the following steps:

The sale of 24 percent of shares in Eesti Telekom in February 1999 reduced the
state's holding in the telecommunications complex to 27.3 percent, plus a "golden
share" that gives the state control over a limited list of strategic corporate decisions in the
period through December 2003. The government will decide by September 30, 2000on
a timetable for the sale of its remaining financial interest in Eesti Telekom;

In 1997 the Estonian railway complex was split into severaloperating
companies and a railway repair and maintenance facility to facilitate its rationalization and
privatization, which is proceeding broadly on schedule. The responsibility for the privatization of
the most important of these operating companies, Eesti Raudtee--the major freight and transit
line--was transferred to the Estonian Privatization Agency in August 1999. We are in the process
of completing work, with the assistance of the EBRD, on the identification of the assets that
would be included in the package to be tendered (including land holdings). We will also need to
decide whether to privatize the entire company as a whole. The privatization of Eesti Raudtee is
expected to be concluded by December 31, 2000.The privatization of the
passenger network (Edelaraudtee) is well advanced, with discussions proceeding with an
interested investor on the scope of future passenger operations in Estonia;

The Port of Tallinn, which is responsible for the operation of four separate ports in
the immediate vicinity of Tallinn, remains wholly owned by the state. In the interest of creating a
competitive, efficient, and transparent environment for the transport of both passengers and
freight--which will become increasingly important as other Baltic ports start competing for the
same markets--early consideration would also be given to the privatization of a 30 percent
stake in the Port of Tallinn to improve transparency and corporate governance.

42. Considerable effort has been devoted over the past several years to the
rationalization and privatization of the Estonian energy complex. Some progress has already been
made with the closure of several oil shale mines. However, more needs to be done. It is
recognized that the need to resolve interrelated economic, social, and environmental issues has
substantially slowed down agreement on a permanent solution. The government's broad
objectives have been (i) to create a competitive market for the generation, transmission, and
distribution of electric power to protect consumers and support the further development of
Estonian industry through ensuring reliable energy supply at competitive prices, (ii) to
address the substantial overmanning in power generation and oil shale production sectors, while
protecting a region hit hard by the Russian crisis and already suffering from substantially higher
unemployment than the rest of the country, and (iii) to reduce the intolerable pollution of the air,
water, and land resources in the northeast of the country associated with the production of oil
shale and the generation of electricity using existing technologies. To address these important
concerns, the government has decided to implement an ambitious and integrated program with
the following key elements:

The government expects to conclude by June 30, 2000 an agreement in
principle to initiate the privatization of the energy sector through the sale of a 49 percent interest
in Narva Power Stations to NRG Company (a US based energy company) with the majority
interest being retained for now by the wholly state-owned Eesti Energia. While Narva Power
Stations will be responsible for the bulk of electricity generation in Estonia, as well as the mining
of oil shale, Eesti Energia will remain responsible for the operation of the national transmission
system as well as most of the nation's distribution companies. As part of this package, Eesti
Energia is expected to agree to purchase from Narva Power Stations a fixed quantity of electricity
annually--equivalent to about 75 percent of the national electricity market for an initial period of
7-8 years and about 50 percent of the national electricity market thereafter through 2014--at a
preagreed price (based on a cost-plus formula). The remaining share of the national electricity
market (initially of up to about 25 percent) is being reserved for electricity producers that may
wish to enter this market in the future.

The new Energy Act which became effective January 1, 1998 has substantially raised
the standards of regulation in the energy industry. It puts a premium on ensuring a high degree of
competition among energy producers with the aim of keeping energy costs low and in this way
contributing to keeping the Estonian economy competitive. An Energy Inspectorate has been
established under the Ministry of Economy to implement the regulatory framework of this Act.
Although the Inspectorate has made a credible start to its work, the government recognizes that
the forthcoming reorganization of the electricity sector will create new challenges for the
Inspectorate, including ensuring open and fair access to the electricity transmission and
distribution systems in a setting where Eesti Energia will retain a major role at every stage of the
process of producing and selling electricity in Estonia. To enable the Inspectorate to fulfill its
responsibilities in this setting an early upgrading of its technical and oversight capabilities will be
required. The government is committed to an immediate review and implementation of measures
required to raise the Inspectorate's regulatory capacity to the standard required to give full effect
to the open energy market as foreseen in the Energy Act and will provide the Inspectorate with
sufficient resources to carry out this mission by June 30, 2000. The government will also keep
under review the option of privatizing the national transmission system and the distribution
companies still under the aegis of Eesti Energia in the event this is seen as necessary to further
strengthen competition;

This ambitious program of privatization and restructuring of the production of oil
shale and generation of electricity is likely to generate economic dislocation in the northeast of
Estonia, including greater unemployment. In the government's view the recovery of this region
will require creating an environment conducive to the rapid and widespread development of the
private sector. In particular, growth of a vibrant small- and medium-sized enterprise sector will
need to make an important contribution to creating jobs for workers displaced from the energy
complex. The government will seek the assistance of the World Bank in developing a
framework for the development of this region. This will also be supplemented by a number of
largely private sector initiatives to promote small scale enterprises to help absorb labor shed
through the restructuring of the energy complex. In addition, the government is encouraging the
development of new commercially viable industries that utilize oil shale so as to mitigate the
impact on the mining industry of the rationalization of electricity production.

43. Although the state has virtually completed the privatization process, a number of
municipalities and local governments still retain substantial interest in enterprises that are active
in areas normally in the domain of the private sector (most are understood to be relatively small).
With a view to establishing a timetable and effective mechanism for the privatization of all such
enterprises, the government will require municipalities and local governments to catalogue all
enterprises in which they have a material interest--subject to a minimum annual sales
volume of EEK 250,000--and submit such list to the Ministry of Finance by September 30,
2000.

IV. Performance Monitoring, Program Review, and Availability of
Purchases

44. Progress in the implementation of the policies under this program will be
monitored through quarterly quantitative performance criteria, structural performance criterion
and benchmarks, and two program reviews. The first review is expected to coincide with the
2000 Article IV consultation discussions, and will focus particularly on the evolution of
Estonia's fiscal position, the pace of economic recovery and its impact on the balance of
payments. The review is expected to be completed with the Executive Board of the Fund by
June 30, 2000. The second review would focus on the budget for 2001 and is to be
concluded by December 15, 2000. Quarterly quantitative performance criteria will apply
to (1) the minimum level of net international reserves; (2) the overall balance of the general
government; and (3) contracting or guaranteeing by the general government of external
borrowing, with separate subceilings on borrowing of maturities of two years or less, and from
two to ten years. In addition, gross foreign reserves of the Bank of Estonia must equal (or be
greater than) the currency board's liabilities at all times. Furthermore, the government undertakes
not to accumulate any external payments arrears at any time during the program period. The
structural performance criterion relates to the submission to parliament of the Basic Budget Law
(paragraph 28 above). These performance criteria are elaborated in the Annex to this
Memorandum, which also contains a listing of structural benchmarks under this program.

1For additional details regarding developments in 1998 and early 1999 and a
discussion of performance under the 1998 precautionary stand-by arrangement, see also
"Republic of Estonia--Staff Report for the 1999 Article IV Consultation,"
SM/99/130, 6/7/99. (Website: http://www.imf.org/external)